What is an Employee Stock Ownership Plan (ESOP)?

In this article, we provide a comprehensive introduction to the Employee Stock Ownership Plan (ESOP) in the United States—one of the most tax-advantaged and widely adopted mechanisms for employee ownership.

ESOPs in the US allow employees to gain ownership stakes in their company through a trust funded by the employer, creating a powerful alignment of incentives between employees and the business.

For a broader exploration of Equity grants, including different types of Employee Share Ownership Plans across the US, Europe, and Asia, refer to this detailed guide.

Introduction

As a founder, you know that your startup's success relies on the hard work and dedication of your employees. Recognizing and rewarding this effort is crucial, and one effective strategy that is quickly gaining traction is the implementation of Employee Stock Ownership Plans (ESOPs).

Apart from being a component of employee compensation, ESOPs embody a shared vision and commitment to the company's future. By implementing an ESOP, you offer stock shares and build a stakeholder community with a vested interest in the company's success.

This blog aims to cover everything about ESOPs. We'll explore their various types, understand their structure, discuss their tax implications, and compare them with 401(k) plans, among other aspects. So, let's get started.

What are Employee Stock Ownership Plans (ESOPs)?

An ESOP is a benefits program that offers employees an ownership stake in the company through stock options. This strategic tool's main objective is to instill a sense of ownership in employees and align their interests with the company's growth path.

ESOPs are generally part of an employee's compensation package, designed to keep employees focused on the company's performance and share price appreciation. By granting ESOPs, you, as a founder, can effectively incentivize your employees and also enjoy several tax benefits. 

However, to safeguard your company's interests, ESOPs usually come with a vesting schedule. This ensures that the employees stay with you until the ESOPs fully vest. Once the shares are fully vested, if the employees choose to stay, they can retain the shares and become shareholders. If they decide to leave or retire, and the shares are fully vested, you have the option to repurchase the shares. If the shares are not fully vested at the time of departure, they are forfeited.

How do ESOPs work?

An ESOP process involves the following stages:

• Establishing an ESOP Trust: The ESOP process starts with the formation of an ESOP trust, which acts as a repository for the shares that will eventually be distributed to your employees. You have the option to infuse cash into the trust to acquire existing shares from the owner(s) at their Fair Market Value (FMV). If the owner(s) are not inclined to sell their shares, you can opt to issue new shares instead.
• Funding the ESOP: If your company lacks the initial funds necessary, the ESOP can procure a loan to purchase new or existing shares. Your role then is to contribute money to the trust fund, which enables it to service the loan.
• Allocating Shares to Employees: Shares from the trust are allocated to employees, usually in line with their pay scale. As they continue their tenure with your company, they earn an increased right to these shares through vesting. It is crucial to note that all full-time employees over the age of 21 should be eligible to participate in the plan. This essentially transforms employees into business owners, providing them with certain control and voting rights within the company.
• Departure of Employees and Share Repurchase: When an employee decides to part ways with the company, they are entitled to their vested stock. You are then obligated to repurchase these shares at their FMV unless there is a public market for the shares. As a result, the employee receives the value of their shares from the trust, usually as cash.

Types of ESOPs

Here are the different types of ESOPs that you can offer to your employees: 

Stock Appreciation Rights (SARs)

SARs are a unique type of equity compensation that provides employees with the benefits of stock price appreciation without actually granting them shares. Instead, employees are given the right to benefit from an increase in the value of a specified number of shares over a predefined period.

SARs can be an interesting choice for companies that want to reward employees for a rise in the company's stock price but prefer to maintain ownership by not issuing actual shares. They offer the financial benefits of stock ownership without the potential complications of share transfer or the administrative burdens of managing a larger shareholder base.

Restricted Stock Units (RSUs)

Restricted Stock Units represent a company's promise to give an employee shares or cash equivalent to the value of shares after a specified vesting period. One of the key advantages of RSUs is their straightforward taxation. Unlike stock options, which require employees to invest in order to realize any gain, RSUs are taxed at the time of vesting based on the Fair Market Value (FMV) of the shares at that time.

However, RSUs also have potential downsides. For instance, because RSUs represent a promise of future payment, they may be perceived as less tangible than actual shares or stock options.

Phantom Stock

Phantom Stock is a unique type of equity compensation that provides the economic benefits of stock ownership without the actual issuance of shares. Instead, it is a promise made by the company to pay an employee a bonus that is equivalent to the value of a certain number of shares. The bonus is paid out at a predetermined future date.

Phantom stock can be an attractive option for businesses that want to provide the financial benefits of stock ownership without diluting the company's ownership. It is beneficial in scenarios where the company wants to reward employees for their contribution to the company's growth but wants to avoid issuing actual shares.

Employee Stock Purchase Plan (ESPP)

An ESPP is a form of equity compensation that enables employees to buy company stock, often at a discount. ESPPs are typically set up as a payroll deduction, with the money accumulated over a specific period (known as the offering period).

ESPPs offer unique benefits for both employees and employers. Employees are provided an opportunity to share in the company's success and potentially realize a return on their investment if the stock price appreciates. For employers, ESPPs can enhance employee engagement and loyalty.

How do you set up an ESOP? 

Setting up an ESOP is a multi-step process that requires careful planning and execution. Here is a simplified guide to help you understand this process:

• Conduct a Feasibility Study: If all owners agree to sell or dilute their shares, the first step involves conducting a feasibility study. This study, which can be performed in-house, evaluates aspects like some text
  • How much surplus cash can your company allocate to the ESOP, and whether this amount is adequate? 
  • It also estimates the cost of repurchasing shares from retiring employees and how you intend to manage it.
• Value the Business: The subsequent step involves conducting a valuation of your business. If the value is too low, the seller might be reluctant to sell. Conversely, if the value is too high, you might struggle to afford the share purchase.

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• Draft and Submit the Plan: Once the valuation is finalized, you should consult with an expert to draft and submit your plan to the Inland Revenue Service (IRS). You can commence making contributions before receiving your letter of determination, which generally arrives within a few months. If the IRS rules unfavorably, you may need to amend the plan.
• Fund the ESOP: Funding for your ESOP can come from a variety of sources: some text
  • The ESOP can borrow money from a bank, the seller, or another party. 
  • Your company can make ongoing contributions. 
  • Employees can contribute to the plan, often through wage or benefit concessions. 

This process must be handled carefully to avoid any securities issues.

• Establish a Process: The final step involves establishing a process to operate your plan. You should choose a trustee, either an in-house individual or an external actor, to oversee the plan. This trustee should be guided by an ESOP committee comprising both managerial and non-managerial representatives. Effectively communicate the plan to employees to ensure their involvement.

Tax Treatment of ESOPs

Here are important details related to the tax implications of ESOPs for companies and employees:

Tax Benefits for the Company

Contributions that your company makes to the ESOP are usually tax-deductible. Moreover, if your company has taken a loan to fund the ESOP, the contributions used to repay this loan may also be tax-deductible. This means that these contributions can reduce your company's taxable income, potentially leading to substantial tax savings.

Tax Implications for Employees

For employees, the tax implications of ESOPs occur at different stages:

• At Distribution: When employees receive their shares at distribution, they pay ordinary income tax on the value of the shares. The value of the shares is added to the individual's taxable income for that year; the tax rate will depend on their total income, including the value of these shares.
• Upon Sale: If employees decide to hold onto the shares after distribution and later sell them, any gains from the sale of the shares are subject to capital gains tax. If the shares were held for over a year, long-term capital gains tax will apply. However, if the shares were sold within a year of distribution, the profit is considered short-term capital gain and is taxable at the applicable ordinary income tax rate.
• 83(b) Election: The 83(b) election is an option where employees can choose to pay taxes at the time of share grant rather than at vesting. This could potentially reduce the overall tax burden if the share value increases significantly over time. However, it is important to note that this election comes with its risks and should be considered carefully.

What Happens When an Employee Leaves?

When an employee decides to part ways with your company, the impact on their equity depends on whether they are classified as a 'good leaver' or a 'bad leaver'. This classification is generally defined in your shareholder agreements.

If an employee is a 'bad leaver', they usually exit your company without the opportunity to retain or convert their options. Conversely, if they're a 'good leaver', they are generally allowed to keep their vested options. They may also have the chance to purchase any unvested options for a nominal fee.

You might provide a specific window during which the options can be exercised or offer a longer timeframe, such as 10 years before the options expire.

However, it is important to note that exercising options upon leaving can carry a risk, especially if the timing of the next opportunity to sell the shares of company stock and cash out is uncertain. Therefore, your departing employees should seek professional guidance before making such a decision. 

Are ESOPs better than 401(k)?

When comparing ESOPs with 401(k) plans, it is essential to consider their unique characteristics. Historically, ESOPs have demonstrated a higher rate of return. In contrast, 401(k) plans tend to experience more volatility due to valuation frequency (annually for an ESOP, daily for a 401(k)) and market fluctuations. Moreover, the annual valuation of an ESOP is conducted by an independent appraiser, enhancing its credibility as an investment option.

Investments in an ESOP grow tax-free until they are distributed. This allows employees the flexibility to roll over these distributions to another retirement plan (including a 401(k)), thereby deferring capital gains taxes until retirement. This feature enhances the versatility of ESOPs as a retirement tool.

In terms of employer contributions, 401(k) plans typically see employers matching up to 4% of the employee's contributions. On the other hand, with an ESOP, employers traditionally contribute an amount equivalent to up to 6-8% of the employee's annual salary at no cost to the employee. This can make ESOPs a potentially more lucrative option for employees. 

ESOP VS 401(k)

Here is a comparative analysis of ESOPs and 401(k) along key parameters:

Structure

• ESOPs: In an ESOP, you, as the employer, grant your employees company stock, making them part-owners of the company.
• 401(k) Plans: A 401(k) plan is a retirement investment account in which employees contribute a portion of their salary, which is matched by an employer contribution of the same amount.

Purpose

• ESOPs: The primary aim of ESOPs is to encourage employee ownership and increase engagement by aligning their interests with company success. ESOPs are developed to mainly invest in company stock, thereby giving employees a stake in the company's growth.
• 401(k) Plans: A 401(k) plan, on the other hand, is focused on retirement savings and financial security for employees after retirement. It presents an extensive array of investment options, allowing employees to diversify their retirement savings.

Benefits to Employees

• ESOPs: ESOPs offer the potential for significant financial gain if the company performs well. Employees have a direct influence on the company's success and share in the rewards via the ESOP.
• 401(k) Plans: 401(k) plans offer tax-deferred growth of investments, a wide range of investment options, and potential employer-matching contributions. This can help to reduce risk if the value of one investment declines.

Risk and Stability

• ESOPs: With ESOPs, employee financial outcomes are closely tied to company performance; this can be risky if the company struggles
• 401(k) Plans: 401(k) plans offer more diversification because employees can choose how to invest their contributions, providing stability in long-term retirement planning.

Benefits and Challenges of ESOPs

Here are the most important benefits and challenges of ESOPs to help you make an informed decision: 

Benefits

• Tax Deferral for C Corporation Owners: As a C corporation owner, selling to an ESOP can offer significant tax advantages. By reinvesting the proceeds in US company stocks and bonds, you can defer capital gains taxes for an indefinite period under Sec 1042 of the Internal Revenue Code (IRC).
• Flexible Sale Options for Owners: An ESOP allows you, as an owner, to sell any percentage of your company's stock, with the flexibility to sell more later if desired. This is a unique advantage of ESOPs, as most private investors would prefer a complete sale of your stake in the company over a partial sale.
• Employee Ownership: ESOPs enable the individuals who have contributed to your company's success to become employee owners. This fosters a sense of ownership and loyalty among employees and also aligns their interests with company's success. 
• Enhanced Job Security: A key benefit of selling a company to an ESOP is the continuity of business that offers job security to employees. This stability often means the difference between employees keeping their jobs and potentially losing them due to a new owner implementing changes like asset sales, downsizing, or relocation.

Challenges

• Fiduciary Risk for Trustees: The trustee of the ESOP, whether an internal employee or an external professional, is held to strict fiduciary standards. This can impose costs on your company in the form of fiduciary insurance or even litigation by dissatisfied ESOP participants.
• Management Complexity: Implementing an ESOP requires significant management effort. From plan administration to legal compliance and cap table management, the workload can be substantial. This can be particularly challenging for early-stage startups where resources and expertise may be limited.
• Regulatory Scrutiny: ESOPs are subject to scrutiny from regulators like the US Department of Labor (DOL) and the Internal Revenue Service (IRS). If the plan has defects, this can lead to additional demands and the risk of penalties.
• Legal Constraints: While ESOPs offer flexibility in many ways, they are subject to certain legal constraints. For instance, ESOP rules mandate that contributions must be allocated as per relative compensation. Additionally, all employees who have worked for 1,000 hours in a 12-month period must be included in the plan, with certain exceptions.

Important ESOP Terms

Understanding the terminology associated with ESOPs is crucial for effective implementation and management. Here are some key terms:

• Vesting: This refers to the process by which your employees earn the right to receive benefits from the ESOP. Vesting occurs over a period of time and ensures that employees who receive ESOPs are committed to your company.
• Distribution: This term describes the method and timing of how your employees receive their ESOP benefits. Distribution usually occurs after an employee leaves your company or retires.
• Leverage: In the context of ESOPs, leverage refers to the act of borrowing money to fund the ESOP. This allows the plan to purchase company shares for your employees.
• Repurchase Obligation: It is your company's responsibility to buy back ESOP shares from employees who leave your company or retire. This ensures that departing employees receive their benefits.

Conclusion 

Setting up and managing an ESOP requires careful planning and execution, considering the potential challenges, such as financial risks, administrative complexity, and legal constraints. If you are a startup founder considering implementing an ESOP, we at Qapita can be a valuable partner in managing your equity awards.

We are rated as #1 Equity Management Software by G2 and offer a comprehensive equity management platform that supports over 2,400+ fast-growing companies globally. Our platform streamlines the equity management process around Cap Tables, ESOPs, and transactions for private companies and startups, ensuring that you always have clarity about your ownership structure. At Qapita, we also provide a structured marketplace to offer liquidity to ESOP holders and shareholders via structured buyback programs and secondary transactions.

Consider scheduling a one-on-one consultation with our experts to learn more about the different implications of ESOPs for your startup. Contact us now to book a demo.